Wednesday, September 28, 2011

Don't Sweat it Greece, Sovereign Default is Normal

Everyone knows* that the sovereign default of England's King Edward III bankrupted Florence's Bardi and Peruzzi banking dynasties in 1345. And everyone knows** that Argentina's default in 1890 brought Baring's bank to the brink of insolvency, staved off by the massive rescue operation organized by the Bank of England.

My question was how common are sovereign defaults?
I found a couple dozen answers in the bookcase and on the 'net but the most interesting came from Bedlam Asset Management.

First a short digression.
The first thing that strikes you is: These people named their firm after the most famous lunatic asylum in the world?
This must be a put on.
Then I read a couple of their market commentaries. They are good. It's not a put on.
I went to their website where the front page says it is for institutional investors only.
No problem.
I click the enter button and am greeted with:

This has got to be a put on. Welcome to Bedlam?
I go back and Google a couple more of their papers. They're erudite and comport with my understanding of markets, economics, finance etc.
So I click on the team page where I see this poor unfortunate:

Richard Greenwood | Senior Research Analyst

6 years industry experience

Joined Bedlam in 2007

Chartered Accountant

Lincoln College, Oxford- BA (Hons) in Classics(1999)

Richard commenced work at Deloitte and Touche in
2003 where he specialized in tax cash flow modeling and due diligence
reports for private equity M&A. His other experience includes
academic instruction; from 1999-2003 Richard taught Classics, Latin and
Greek at Wisbech Grammar School.

Rob first worked at Bedlam as an intern then
joined full time after gaining his degree in Business Administration.
Robert is also a Non-Exec Director of a London Wine Merchant.

I'm really thinking this is a put on.
But another part of me says "Hey if he is a director at, say, Berry Bros. & Rudd..."
All morning I've been quoting that line William Goldman put in Butch Cassidy's mouth as the posse tracked he and Sundance relentlessly:

"Who are these guys?"

Just a few minutes ago I was shown that they were vetted by FT Alphaville's Izabella Kaminska.
That's good enough for me.
Here goes. From Bedlam Capital Management PLC, March 14, 2009:

Sovereign default“Dictum meum pactum?”

The world of high finance is full of charlatans; those who claim never to have been duped arelying or unaware. When clinching a deal, these fraudsters seize your hand in a manly butfriendly grip, look you in the eye and utter the immortal phrase “my word is my bond”. Inolden times, the 1990s, the more professional crooks would often say “dictum meumpactum”*. This means the same thing but being in Latin shows great erudition, thus addingcredibility. If a man (and usually it is a man) insists on telling you he is honest, something’sseriously wrong. Today, more dubious people than ever are saying ‘trust me’, and investorsare doing just that. Having lost millions to one group of hustlers – be they funds of hedgefunds, SIVs or structured products - they are now fleeing by the billions of dollars to otherfraudsters: central bankers selling the perceived safety of government bonds. Moreover, sogreat is the issuance of these IOUs that inevitably there is a giant crowding out effect on theprivate sector borrower. This ensures that bankruptcies accelerate, thus bond issuance mustdo so as well.

Although objectively (sic) we are the greatest living authority on bank valuations and cycles(as the only firm in the world never to have held bank shares in the English speaking world),we make no claims as bond experts. Despite this caveat, we do understand when supply anddemand are chronically out of balance. Such analysis on bonds suggests that financialmarkets are in for the worst shock of all – a series of Sovereign Defaults. ‘Don’t know where,don’t know when,’ as the Platters used to croon, but this time default will not just be a thirdworld problem but will include some industrial nations.

Mankind is a natural herd animal. Criticising the status quo is never popular. Only when ithas become blindingly obvious that the decision makers and leaders are unquestionablyidiotic and their policies disastrous does the herd tear them to pieces. This is often whendefault occurs. Debt markets and politicians are not prepared for these events. Given theatrocious supply/demand dynamics, trusting in government issued paper is now one of theworst investments anyone can make.

What is a Government Bond?Until recently, none of us had ever read in full what is written on an American or Britishgovernment bond or the offer documents. There are lots of words and caveats, not dissimilarto Bank of England bank notes with their lingering promise from the days when these notescould be redeemed in gold.

Government bonds are the standard benchmark for risk. Their yield sets the borrowing costsfor everyone else. There is logic to this, as in theory the obligation to pay at some future dateby issuing government paper in prudent quantities can always be met through changing taxrates or curbing government expenditure to raise the necessary funds. The promises are moreexplicit than bank notes and commit future governments to meet these liabilities even thoughtheir leaders may not yet have been born.*Also the motto of the London Stock Exchange. Enough said.

Default is normalIt is not widely realised that governments failing to meet their debt obligations areastonishingly normal. Indeed, it is utterly abnormal for a country to have a track record longerthan three generations of paying back IOUs issued by dead people. The chart below shows thenumber of countries in default of their sovereign obligations in each year since 1823.

This chart understates the true extent of default; for at the sub-national level many states orcities - such as four American states in the 1830s (well before the civil war), or the City ofCleveland (Ohio) in 1978 - defaulted on their bonds. China created havoc in the late 1990swhen several of its local state-owned investment companies defaulted. Beijing-basedpoliticians and the central bank had always suggested they were government backed. Whenthese investment companies gambled themselves into bankruptcy, bond holders hiredtranslators and discovered they were not even backed by the regional governments which hadissued them. Meanwhile the Politburo developed collective amnesia....MORE

If you meet BCM's requirements do read their Q3 Global Investment Review and the Monthly Bulletin for September.